Second Life's looming tax threat

Come April 15 profits earned online must be reported to the IRS. But what about 'money' that's virtual?

NEW YORK (CNNMoney.com) -- In case you haven't noticed, Second Life is booming, and its economy has boomed too - putting the virtual reality world in the crosshairs of tax authorities, experts say.

Entrepreneurs have flocked to Second Life - a computer-based 3-D virtual world where users create their own, well, second lives - in pursuit of making real money. So-called residents can buy and sell goods for Linden dollars, an in-world currency that can be converted into real U.S. dollars. (See how real money works in Second Life).

HOW SECOND LIFE WORKS

Second Life is a virtual world that anyone with a broadband Internet connection can enter. Users download software and create an avatar - a cartoon-like character that they control with their mouse and keyboard that represents them in the digital world.

When users login to Second Life, they begin the in-world experience. Using the software's tools, they can create objects and communicate with other virtual residents via instant messaging and voice services.

At least one user claims the virtual world has minted her a millionaire - and economic activity is humming along. Users of the virtual world injected about $1.6 million into Second Life in the last 24 hours alone, according to Linden Lab, the creator of Second Life.

Under current tax law, it's clear that earnings in real U.S. dollars generated within virtual realities are reportable to the IRS. If a Second Life real estate mogul cashes out of her in-world property portfolio, she's liable to pay income tax on any profit that's been exchanged into real greenbacks - just as an eBay (Charts) seller is responsible for reporting income generated from an online sale.

Tax law is murky, however, when it comes to dealings that occur solely within Second Life or other computer-simulated environments. For instance, is a transaction that occurs only in Linden dollars and doesn't involve any real-world, dollar exchange taxable?

Questions like that have the tax community buzzing about the issue, said Paul Caron, a professor at the University of Cincinnati who edits the TaxProf Blog.

The issue has also attracted the interest of the Joint Economic Committee of Congress, which said last fall that it was studying issues related to the economies of virtual realities like Second Life and World of Warcraft, an online role-playing game.

Results of the study - due to be released before the end of the month - suggest that "as long as virtual activity stays within the virtual economy, it shouldn't be taxable," said Christopher Frenze, executive director of the JEC, which conducts policy research on economic issues facing Congress

But there is a valid argument that even profits that come from, and stay in, the virtual world are taxable, according to Bryan Camp, a professor at Texas Tech University School of Law. "As soon as you start looking at what's going on in these worlds, they look a lot like real economic transactions," he said.

Even if profit isn't realized in real dollars, there's still an exchange of items of economic value. In the real world, if someone trades goods or services without the exchange of real money - also known as bartering - that's a taxable event, Camp noted.

Given all the attention paid to the topic, the IRS eventually will have to respond to the situation, said Caron. "I think it's on the IRS's radar screen in a way it was not six months ago," he said.

When asked about the agency's position on collecting taxes from virtual economies like Second Life, an IRS spokesman offered the following comment via e-mail: "Any time someone wins a tangible prize or award, the value is reportable as taxable income. An accumulation of 'points' would not result in tax consequences, but redeeming or selling them for money, goods, or services would."

Edward Castronova, a professor at Indiana University who heads the Synthetic Worlds Initiative, a research center focused on online communities like Second Life and World of Warcraft, doesn't see taxes on virtual-only transactions coming anytime soon.

But "in the next three or four years, we'll likely see it. In the next 10 years, there's no question about it," he said. "If you look at these transactions, they're huge."

For its part, Second Life operator Linden Lab isn't concerned about looming tax regulations on virtual economies, at least not yet.

"Given the reassuring statements from the JEC, it's pretty clear this is a moot point," a spokesman for San Francisco-based Linden said. "Linden is focused on what it does best - scaling technology and building Second Life's platform."